Facebook buys Instagram: is the latest internet bubble about to pop?

One billion dollars for a company that has not even hit its second birthday,
makes virtually no money and has just 13 employees on its payroll. It all
sounds a bit fantastical – and worryingly familiar.

Instagram will allow users to edit clips and add its hallmark frames and filters to give videos a retro feelPhoto: Getty Images

Facebook's acquisition of Instagram has immediately sparked fears of another dotcom bubble, turning a handful of bright entrepreneurs into overnight multi-millionaires but threatening to leave a wider pool of investors with their fingers badly burnt.

Kevin Systrom and Mike Krieger, the two young Stanford University graduates who developed the addictive photosharing app, will make around $400m and $100m respectively from the deal. Mr Systrom, who turned down a job offer from Facebook in 2004 in order to finish his studies, joked that the sale will enable him to afford a few more bottles of Champagne. With that sort of money he could buy the Champagne producer and a lot more besides.

Facebook has doubled the value put on Instagram just a week ago, when it closed a $50m funding round from investors including Sequoia Capital. Put another way, it has paid $80m per employee and more than $33 for every one of Instagram's 30m users. It's even valued the company ahead of The New York Times, which has a market capitalisation of $942m.

This trajectory and these sorts of overnight riches call to mind the gold rush of the late 1990s and early 2000s, typified by AOL's $400m payout for Mirabilis, an Israeli instant messaging firm, or Lastminute.com's extraordinary flotation. The online travel business placed at 380p a share in March 2000, two years after its launch, valuing the business at £571m and netting its 20-something founders, Brent Hoberman and Martha Lane Fox, £300m.

On its first day of trading, its share price closed at 492.5p, turning the pair into the posterchildren for dotcom success. However, within weeks Lastminute's share price had dropped to below 190p, and markets around the world crashed as rattled investors cashed out of the sector. More than $1 trillion was wiped off the US markets in a single day.

There have been other high profile casualties since then. ITV bought Friends Reunited for £120m in 2005, but four years later sold it to DC Thomson, owner of the Beano, for just £25m. Last year DC Thomson told shareholders Friends Reunited was worth just over £5m. Similarly, News Corporation shelled out $580m for MySpace in 2005, but booked a $545m loss when it sold the company last year to an online advertising venture backed by the singer Justin Timberlake.

However, Facebook's Instagram deal also has shades of the social network's own early days. In 2006, Facebook was locked in talks with Yahoo! over a $1bn sale. Yahoo! lowered its offer to $800m late in the day but many analysts were still stupefied that Mark Zuckerberg, Facebook's founder, walked away. To say he was vindicated is an understatement. Facebook's own IPO next month is expected to value the social network at more than $100bn – 25 times its historic revenues, 100 times its net profits or, alternatively, around $117 per user.

Of course, sceptics could be forgiven for joining the dots between the two events. Facebook's flotation is much more likely to go smoothly if technology valuations are high. However, much more likely is that Facebook recognised in Instagram a similar growth story to its own, and a huge potential threat.

Mr Systrom and Mr Krieger have rapidly built a network based on sharing photographs – arguably the cornerstone of Facebook and the feature most often cited as the reason people join in the first place, or feel they cannot leave.

Sam Hamadeh, chief executive of PrivCo, a US research company which studies privately-held businesses, claims it was a defensive buy. "This is not about money making now... it is trying to buy out the next Facebook," he says.

It is also about preventing others from doing so.

According to reports, Google also held talks with Instagram within the last month, helping to drive up the price. Ray Valdes, an analyst at Gartner, the technology research firm, says: "You can view the $1bn as an insurance payment against a possible mortal threat if it fell into the hands of one of its competitors. If Facebook is valued at $100bn, 1pc of that figure seems like a reasonable payment."

The deal will also drive up the price of competitors. Mr Hamadeh estimates that Tumblr, another photo-based social networking site, and Pinterest, a “digital pinboard” that allows users to share photos and other favourite items, are likely to go for $2bn apiece.

But while the ripple effect will be broad, Mr Valdes expects just a handful of companies to see an Instagram-style spikes in value.

"The downturn and the last dotcom bubble will have a sobering effect," he says. "There are still some deep scars that have left lasting memories."